Asset management - CFS, from cast-off to market leader

Greg Perry

Riding the wave better than any long-established group, one Australian fund manager has in 10 years risen from insignificant subsidiary of a troubled state bank to industry leader with international growth plans.

Five years ago, the business that eventually became Colonial First State Investment Managers (CFS) was virtually given away. Since then, and almost by accident, it became the Australian financial markets success story of the 1990s. It is now worth at least A$2 billion ($1.23 billion).

Strong performance is part of the explanation. One of the CFS unit trusts, the Developing Companies Fund, was the top Australian equity fund of 1999, with a return of almost 100%. Over the past five years, two of its flagship funds have been in the top five Australian domestic equity trusts. Its Imputation Fund is the largest retail equity fund in Australia.

It is already the second-largest fund manager in Australia, behind the 150-year-old AMP. It was hailed as the overall fund manager of the year by Money Management magazine for 1996 and 1998.

Graham Rich, managing director of research house Morningstar Australia, says: "It has significantly superior quality across all aspects of its business. Management has melded together an excellent team of people, handled a period of vast growth and managed it exceptionally well."

CFS began operations in late 1988 managing A$175 million of superannuation money for its owner, the State Bank of New South Wales. Like most Australian banks, State Bank of New South Wales struggled through the early 1990s under the defaulting loans of entrepreneurial disasters such as Alan Bond's Bond Corporation, Russell Goward's Westmex (and Charterhall in the UK) and Christopher Skase's Qintex.

Between 1989 and 1993, State Bank created bad debt write-offs and provisions of A$830 million on a A$17 billion dollar book, while fellow state banks in Victoria and South Australia disappeared leaving $A6 billion of debts for their respective states. Facing the most severe recession in 60 years, by 1993 New South Wales state treasurer Paul Keating was desperate to sell off State Bank. Almost as an afterthought, its fund manager was thrown in for free.

Peter Polson

From the outset he insisted that all staff adopt a set of brand values that mirrored his own personal ideals: passion and intelligence in developing the business, responsibility for results, and transparency and honesty. "Smart arses don't get five minutes here," he says.

Greg Perry, Cuffe's head of Australian equities, rapidly demonstrated an awesome ability to pick outperforming stocks. His investment method focused on companies whose earnings would grow faster than the economy. In 1990, Perry won the first of his Money Management awards in the equities category, and has stayed at or near the top ever since. "We discovered that buying companies that are expected to grow faster than GDP automatically led us to companies at the cutting edge," says Perry "We minimize risk by further checks on balance-sheet strength, management strategy and history, but we find that the same growth features are also tremendous defensive characteristics when the market corrects."

Unlike many bank competitors, Cuffe's distribution strategy was to target the burgeoning financial advisers, planners and accountants that Australians flocked to for advice. "I believe," he says, "it's impossible to survive without financial planners unless you are one of the big-four banks. Our funds inflow is quite the opposite of the major banks, such as Westpac and Commonwealth, where I'd say 90% comes from retail branches. The medium-to-high-net-worth individuals have turned to financial planners and the like for advice. The person with half a million dollars does not generally walk into a branch." CFS paid healthy trailing commissions, and aided by Perry's performance and an efficient back office, it built a strong reputation among its new constituency.

Although Cuffe was winning external accolades, he had few fans within State Bank, whose strategic advisers questioned the role of a fund manager in a struggling bank. For many years, the funds flow from State Bank branches was a trickle. It was not until 1994, shortly after CFS reached its first A$1 billion under management, that State Bank managing director John O'Neill openly declared that the fund manager was a core part of the business. But it came too late. At about the same time, the state government formally announced the proposed sale of its bank.

Faced with an uncertain outlook, Cuffe and his team had many anxious months speculating about new owners. It unsettled the business. "External advisers and referral groups put us on hold, and the business going was tough," says Cuffe.

Fifty-four initial expressions of interest to buy State Bank by the January 1994 deadline became only one by October 1994, and Colonial's managing director, Peter Smedley, pulled off the deal of the decade. He paid roughly the equivalent of net assets, A$576.5 million. Even better, the government agreed to pick up 90% of bad loans beyond the first A$60 million. Emphasizing the Colonial bargain, only six months later Advance Bank paid 1.7 times net assets for the old State Bank of South Australia, and later St George Bank paid 2.6 times for Advance.

Chris Cuffe

Throughout the sale process CFS was virtually ignored by potential buyers. The report to the state auditor general, prepared by Credit Suisse First Boston and Coopers & Lybrand, on the proposed sale of State Bank did not even mention the fund manager. The jewel in State Bank's crown was given away.

The final result was the best Cuffe could have hoped for. After years of uncertainty, his first request to Smedley was to issue a public statement that the new owners would not interfere with the running of the funds business. Colonial desperately needed a bank to complete its financial product range but it already had a fund manager in Colonial Investment Management. Polson resisted the urge to simply fold First State into the existing business. "We soon realized First State had modern systems, a better call centre and a strong brand awareness among independent financial advisers. Colonial, as manager for a life office, was an old-fashioned, fuddy-duddy place, and a long way behind. I didn't want to move everything to the lowest common denominator, so I allowed First State to pull everything else up. Once they built a more balanced business, a wider product range to wholesale and retail clients, we folded Colonial Investments into First State."

Cuffe calls 1996 his "year of explosive growth", culminating in winning the 1996 Money Management fund manager of the year award. By 1997, CFS was no longer a boutique fund manager, and reached the top 10 in retail funds under management. Polson knew Colonial had hit the jackpot, and had bought something special. "I have been involved in funds management for many years all over the world, and I have only ever met four people who are serious money-makers. Greg Perry is one of them."

Perry has developed an enviable reputation as a canny stockpicker. He is modest about his achievements, and makes it sound simple: "We look for a quality company at a fair price, not a poor company at a bargain price. We have been able to stay clear of the losers, such as Pacific Dunlop, Email, CSR and Boral, where we could not see the growth. The same applies to Coles Myer, which already has 20% of retail expenditure." He was an early mover on the banks as they benefited from reduced costs and economic growth. He was once the biggest investor in Australian telecom giant, Telstra, although he picked the recent sell-off and is now underweight.

Perry views Australia as a country with enormous infrastructure needs, and this led him to invest in toll roads and stevedoring. He studies changing demographics to identify trends and is a great believer in the possibilities of the internet. This led him to excellent returns on Kerry Packer's Publishing & Broadcasting and newspaper group Fairfax. He also rode the Harvey Norman success story as the franchiser expanded beyond New South Wales.

Backed by Perry's remarkable returns, CFS grew rapidly, but it was not until 1998 that it really hit the big time. Almost by accident rather than design it received three massive injections of funds in the space of five months. In May, Colonial moved all its fund-management businesses from Melbourne to the operations of Sydney-based CFS. In July, Colonial purchased the Australian insurance business of Legal & General, and topped that by buying Prudential in September. With each purchase came a large fund management operation, and assets quadrupled. Investors soon exceeded 400,000. The strain would have killed many businesses. But as Morningstar's Rich explains: "Whether they wanted it or not, massive chunks of money were thrown their way, and they haven't faltered at all."

Cuffe is sanguine about the ability to merge four large fund operations in a few months. "We were stronger in all facets of the business. It was easy to decide what to retain and what to gobble up. We have developed a clinical approach to opening and closing funds."

Cuffe says that they could not have coped with such expansion if the Colonial management team had not left his team to run the business. "I'm convinced a high-control environment won't work for a rapidly growing business," says Cuffe. "Some years, we had a 100 per cent increase in staff and capital expenditure. That takes a lot of trust."

In 1999 the distribution strategy developed a decade earlier paid off handsomely when a survey of 381 financial advisers awarded CFS the ASSIRT top service provider and fund manager award. Brett Sanders, general manager at ASSIRT, Australia's leading managed investment research firm, says: "Colonial First State's meteoric rise is due to a number of new services they have introduced for advisers in the last 12 months. Colonial First State has set up a dedicated adviser services centre to handle advisers' queries, plus real-time internet software for advisers to access the latest information on their clients' portfolios, as well as significantly growing the number of people resources with a dedication to servicing advisers."

In retrospect, it could not have been a better time to be in funds management in Australia. By the end of 1999, the country had experienced 100 months of growth for the first time. The stock market index, which touched 1200 in the 1987 crash, reached 3150. Even better, the introduction of compulsory superannuation forced Australian employers to contribute to the savings of employees, initially at 3% of wages, rising to 9% by 2002. By September 1999, superannuation funds managed A$415 billion in assets on behalf of 19.7 million member accounts, covering 91% of employees. As recently as 1994, superannuation funds had accounted for only A$203 billion.

CFS picked up a lion's share of this growth, and gradually caught up with the first successful external fund manager in Australia, BT. BT established itself as a market leader in the 1970s, crowning its success by hedging its fund performance during the 1987 crash. Graham Horrocks, previously general manager, research & quality assurance at Ord Minnett, and now an independent actuary and financial planner, says that many tried to claim BT's mantle, including County NatWest, Rothschild and the banks, but "they all failed significantly". CFS is now the first fund manager recommended by Horrocks to his clients. "They are the only ones who have been able to take on and achieve equal status with BT. CFS may be number one. I rely on them doing well or I need to put a lot of money somewhere else."

Horrocks places 40% of his funds with CFS, 40% with BT and 20% with the rest. He is particularly pleased that Principal recently bought the BT business. "Principal is a far better manager than Deutsche ever would have been. And BT's New York parent was never really committed to the business." Although Horrocks is in the legion of CFS fans, he adds a note of caution. He claims that while their equity funds have achieved almost "mythical status", their cash and property funds are not in the same league. And he always uses the Macquarie Cash Management Trust for its superb execution.

Another feature of a fund manager with over 50 products is what Cuffe calls a hub-and-spokes approach. Retail funds buy units in the relevant wholesale funds, rather than being managed as a new retail fund. A diversified fund with an equity component will not have its own management running a unique portfolio, but will buy units in the existing Australian Equity Fund, according to proportions defined by a set of rules. Similarly, bureaucracy is minimized by the absence of a chief investment officer, which is highly unusual in funds management. It empowers a tight team of 75 investment professionals to be responsible for their own actions.

A classic example of avoiding the bureaucratic process was CFS's innovative Geared Share Fund. Cuffe sounded out Geoff Walker on whether there was potential for a retail fund where the gearing was built into the structure. Walker, now principal at William M Mercer's Fund Manager's Services, explains: "I'd wondered why there was nothing like it in the market, so we developed it together. It was tricky, because normally a geared investor has other sources of income and security, and usually plans to wind down the investment. None of this applies for a trust." They designed a geared product with no margin recourse to the investor, removing a major obstacle for retail customers. The dividend flow from investments pays for any borrowings. If the dividend yield (net of expenses) is 5% and the cost of borrowings 10%, the fund is geared at 50%.

Although both Cuffe and Perry are locked into Colonial on attractive options packages (and the share price rose from A$2.60 at the May 1997 listing to almost A$7 at the end of 1999), Morningstar's Rich believes CFS would survive the unlikely event of a departure of both. "While it would be a serious loss if either left," he says "they have inculcated their disciplines, styles and understanding sufficiently to ensure continuing success."

In February 2000, ASSIRT announced that CFS had recorded the biggest growth of any manager in the country in the three months to the end of December, to A$43.5 billion. In late 1999, CFS purchased the unlisted private-equity business of venture-capital experts Hambros-Grantham. It merged four smaller listed property trusts to create the Colonial First State Property Trust, the fifth-largest in Australia with a market capitalization of over A$1 billion. And again moving before other managers, CFS introduced the Global Technology & Communication Fund in November 1999, and within two months attracted almost A$50 million and booked a unit price rise of 38%.

The challenge is now to expand internationally.

CFS has already made major progress in Asia, including several acquisitions, but the UK and Europe remain significant targets. "We tried to consolidate our global business in Sydney, but we realized it is not the international centre that London is," says Polson. "Europe is on the doorstep, and it is a good place to research business from. We now have 35 global equity investment professionals in London, and £5.4 billion [$8.6 billion] under management there." Cuffe also praises the London move for giving greater access to global companies. "We had more company visits within the first four weeks of arriving in London than in the previous 18 months."

Confirming its ambitions in the UK, Colonial bought the Edinburgh-based fund manager Stewart Ivory in February 2000, adding about $A7.7 billion to funds under management. Colonial will make payments over five years to ensure key staff are retained. Stewart Ivory manages around $2 billion of United States funds with Massachusetts-based group Babson,giving CFS its first foothold in the North American market.

Chris Cuffe, CFS's chief executive, talks to Graham Hand about the organization behind his company's success

How has First State handled a period of dramatic growth, especially on the computer systems side?

When we started, there was no off-the-shelf software. I personally dislike outsourcing, as the heart of the business is servicing people, and those who leave it to consultants are being conned. So we designed the systems ourselves without attempting to build a Rolls-Royce, with talented IT people doing their own thing. We used the bank's hardware but I insisted we must have our own programmers.

And the IT staff have been able to grow with the business?

We moved them into our offices, next to the business decision-makers, and the senior IT staff report directly to me. We have kept the key people, especially Derek Ngoh. We have moved from being a registry to using imaging and voice response, then we built our own website, the first to have real-time interactive response to our mainframe, then data warehousing and straight-through processing. Although we moved rapidly from 30,000 to 400,000 investors, we never had a doubt that the bank's mainframe could handle it. That was a fortunate aspect of being part of the State Bank of New South Wales.

But you still needed to handle thousands of new customers each month.

The big breakthrough came at around 30,000 investors, when we knew we had to move to imaging and workflow efficiencies. We did not have capex freedom, but I couldn't see how anything could work for records management other than an image. Our paper-based systems were falling over.

Is it true that as recently as late 1993, despite having won numerous awards and a growing customer base, the strategic planners in the State Bank placed little value on the business?

Yes. They never thought we would be a success. We had several meetings at the end of 1993, where I was trying to get the bank to wholeheartedly back us. The only focus was profit. We were told if the bank could get $2 million for the business, it would accept. Geoff Walker and I talked about buying it.

How did you feel about the purchase of the State Bank by Colonial?

I told my colleagues at the time that it was the best possible option. Their own funds management side was extremely weak, so they were least likely to want to change us. I also felt [Colonial managing director Peter] Smedley and Co would have no sacred cows, no hidden baggage, being originally from outside the banking and insurance industry. I also believed it was Colonial's last throw of the dice, and they were therefore likely to be highly energetic business people. I felt very comfortable with Colonial. They kept their hands off First State.

But the uncertainty around the sale of the bank caused problems for you?

Yes, some fund managers and rating companies put us on hold, and others didn't believe the way we were managing money was right, so we were fighting a few fires - 1994 was a difficult time for investment markets generally. It was amazing how quickly it turned around in early 1995. I take my hat off to [head of Colonial's worldwide fund management] Peter Polson. He saw the importance of firewalling us, he picked up quickly the fierce independence and did not want to interrupt it. In 1995, the funds inflow absolutely skyrocketed. Polson realised that a high-control environment would not work with a rapidly growing and changing business.

How do you keep staff doing what they are good at rather than paperwork as the business grows?

At the end of the day, if you've got smart guys, you provide the framework and the rules become more like principles. I can provide the playing field and be the umpire. Then I say: "Let the players get on and play the game." We don't build layers, we've never had a chief investment officer. At our roots, we are a good administrator.

So when did you feel First State was entering the big time?

Probably by 1996. We were past being a start-up, we had a good owner, with a huge brand awareness. We were assured of always receiving a lot of money under compulsory superannuation. It was also then and into 1997 that we seriously widened our range into property and international shares.

You had a great year in 1996. Why?

It started to take off in late 1995. The sale of the State Bank was out of the way, and a number of competitors were starting to shoot themselves in the feet. They were embroiled in takeover and merger activity, and had some poor results. BT slowed down in terms of how much momentum they could extract from their 1987 success, and they changed their commission structures and totally upset the financial planning community. Through all that we picked up awards and performed well.

Why did it take so long to move to establish your own international equities team, rather than operate through alliances?

It's a question of critical mass - when to take the step to do your own thing. We knew Australia was only 1.6% of global equities and under-represented in some industries, so we needed to get bigger in other markets. I reckoned you needed a minimum of 20 professionals to cover the market properly. Now we are well ahead of the MSCI.

You personally decide which funds CFS will launch. Can you talk me through the establishment of a new fund like the Global Technology & Communications Fund.

I was in London in July 1999. I was hiring a couple of global industry analysts who wanted money to invest as well. I thought I could organize some internal money, but decided to survey the market for a technology fund. Investors had an excitement and fear about the market, they wanted to be on the rollercoaster but could not find the right stocks in Australia. Within 48 hours of asking Rob Adams, who heads our distribution, to check with financial planners, we had decided to do it. We thought it would be good, but it has knocked the socks off us, taking nearly $50 million in two months over Christmas without any advertising.

What, no board meetings, no lengthy systems work, no detailed sign-offs?

Over time, we have developed a sixth sense on what will work. We put together an adviser's kit, a prospectus, did the staff training. The systems amendment was a new code on a line, it took a few minutes.

Underneath it's a standard unit trust. We were telling financial planners about it as I was getting off the plane.